The Impact of the Upward Redistribution of Wage Income on Social Security Solvency

The impact of the aging of the U.S. population on the finances of Social Security has been widely touted by the media and Washington pundits. While these demographics do raise costs for the program, this is hardly an unbearable burden and it certainly is not a surprise. We have known about the baby boom for more than 50 years.

What is newer and was less widely anticipated is the upward redistribution of income that we have seen over the last three decades. This affects the program in two ways. First it has a direct effect in that a larger share of wage income has gone over the taxable maximum (currently just over $113,000). In 1983, the Greenspan commission set the cap at a level where 90 percent of wage income would be subject to the tax, meaning that 10 percent would escape taxations.

Since that date, the upward redistribution of wages has increased the portion of wage income over the cap to 16.8 percent, with just 83.2 percent of wage income subject to the cap. The share going over the wage cap is projected to rise further, reaching 17.5 percent of wage income in a decade. In this way, the upward redistribution of income directly worsens the finances of the program.

However there is also an indirect effect. If wages had kept pace with productivity growth over the last three decades, the typical workers would be paid around 25 percent more than they are now getting. In an environment of growing wages the prospect of increased Social Security taxes may not seem as bleak as in the environment of stagnating wages that we now see. While it is difficult to know how the political situation would differ if wages had kept pace with inflation, it is worth noting that even now workers would prefer higher payroll taxes to cuts in benefits according to a recent poll by the National Academy for Social Insurance.

The chart below shows the path of Social Security revenue and spending if there had been no upward redistribution of income over the last three decades. [1] In 2012, if 90 percent of wage income has been subject to the tax then the system would have raised another $58.1 billion in taxes. It would have paid out an additional $15.7 billion in benefits for a net increase in revenue of $42.4 billion, before counting the additional interest.

Source: SSA and Author's calculations, see text.

Taking the cumulative net gain in revenue over the last three decades in the event there had been no upward redistribution of income, and imputing a 6.0 percent nominal interest rate, the trust fund would have $1,232 billion more in assets than it does at present. This is equal to 13.5 percent of the $9,101 billion shortfall for the program’s 75-year planning period projected in the 2012 Trustees Report (Table IV.B5). If the tax continued to cover 90 percent of wage income, this would reduce the projected shortfall by 0.80 percent of covered payroll, an amount equal to 30 percent of the projected shortfall.[2]

Taking these two factors together, if there had been no upward redistribution of wage income from 1983 to the present and the tax was projected to continue to cover 90 percent of wage income over the program’s 75-year planning horizon, the shortfall would be 43.5 percent less than what is currently projected. While this is still some distance from complete balance, the upward redistribution of wage income has been an important factor in the deterioration of Social Security’s finance. And, unlike the decline the ratio of workers to retirees, this upward redistribution was not an event that was anticipated by the Greenspan Commission when it designed a plan to secure 75 year solvency in 1983.

[1] The calculations for additional tax revenue were obtained by multiplying tax revenue by the gap between 90 percent of wages and the actual amount of tax coverage, divided by the share of wages covered (0.90 – covered wages)/ covered wages. The share of wages covered can be found in the Social Security Annual Statistical Supplement, Table 4.B1 http://www.socialsecurity.gov/policy/docs/statcomps/supplement/2011/4b.pdf. Annual revenue are can be found in the 2012 Social Security Trustees Report table VI.A3 http://www.ssa.gov/oact/tr/2012/VI_A_cyoper_hist.html#215892. The calculations for the impact on payout assume that the additional revenue is credited to the earnings of workers whose lifetime income puts them above the 15 percent bendpoint. It assumes that the current payout averages 40 percent of lifetime earnings so that additional payments would rise by 0.375 times (15/40) the amount of additional revenue once the full impact is felt. Since the payouts come after the revenue is received, the calculation assumes that this increase is phased in at the rate of 0.04 percent annually, so that after 25 years the full effect of a higher taxable base would be felt on the payout schedule. In effect this means that after 25 years all beneficiaries would have been subject to a higher ceiling during their working lifetime. The impact of the higher ceiling is assumed to be the average gap (as calculated above) over the prior thirty years. These simplifying assumptions likely overstate the higher payouts that would result from raising the cap.